Monday, December 10, 2012

It's the capital gains rate, stupid!

In last week's WSJ Peter Schiff has a piece debunking... well, it's actually a little hard to tell what he's trying to debunk. The title of the piece is The Fantasy of a 91% Top Income Tax Rate, but of course it is undeniable that there once was a rate this high (actually, tax rates topped out at 94% in 1944). But Schiff argues that this rate wasn't "real" because of the myriad tax shelters and loopholes that were available at the time. So were the effective tax rates, net of loopholes, higher then than now?

That is a tricky question to answer (as evidenced by the labyrinth of figures in Shiff's piece, some of which he originally got wrong). But it's also the wrong question to ask because it ignores the real elephant in the taxation living room: long term capital gains. (Actually, the real elephant is a wealth tax [1], but that is so far off the radar in today's political climate that one risks being taken for a left-wing nutjob merely by uttering the phrase. So I won't.)

Let's take stock of the last 100 or so years of economic history. In 1926 the capital gains rate was 12.5% and the top marginal income tax rate dropped from 44% to 25%. Three years later, the Great Depression began.

In 1944, the capital gains rate was back up to 25%, and the top marginal income tax rate was a staggering 94%. That was quickly reduced to 91%, but over the next thirty years it was never lower than 70%. Over this same thirty-year period, unemployment was 5.5% or lower for all but one year (1958, when it spiked to 6.8%). The capital gains rate rose as high as 38% in 1979.

In 1981 the capital gains rate was reduced to 20% and the top marginal income tax rate was reduced to 50%, then to 28% in 1988. In response to increasing deficits, the income tax rate was raised in 1992 and again in 1994 (by a Republican Congress working with a Democratic President, it is worth noting). The deficit shrank to zero. Unemployment shrank to 4% in 2001.

In 2003, the capital gains rate was reduced to it current 15% and top marginal income tax rates to 33%. Five years later the Great Recession began.

Now, of course none of this proves a causal relationship between high taxes and general prosperity or low taxes and economic disaster, but the correlation really is quite remarkable. The last hundred years have been bookended by two periods of dramatically low taxation, which just happen to correspond (with a 3-5-year delay) with economic catastrophe. In between we had three decades of high taxation and uninterrupted prosperity. If there isn't a causal relationship, it sure is one helluva coincidence. But no matter how you slice it, there is only one theory that the data could conceivably debunk, and that is the one that says that rich people are job creators, and that taxing them exacerbates unemployment.

There is, of course, a very plausible model of why higher taxes can help promote prosperity: jobs are not created by wealth (it's actually the other way around: wealth is created by jobs). Jobs are created by demand. Enmployers don't hire people because they have money, they hire when -- and only when -- there is more demand for their product than they can meet with their existing work force. So it is no coincidence that prosperity coincides with high marginal tax rates (and, I might add, strong labor unions). The best way to generate demand is to, as conservatives like to say, "broaden the base" and operate under rules that benefit the middle class and poor even if this comes at the expense of the very rich. This is because the less money you have, the more of it you spend as a percentage of your income. A single person can only consume so much, so a million dollars in the hands of one person produces less demand (and hence fewer jobs) than the same million in the hands of, say, ten people.

Now, please don't mistake this as an endorsement of communism. I am a proud born-again capitalist. I do not believe in equality of outcome. There has to be some incentive to work harder and take more risks. But there also has to be some countervailing force to balance out the disproportionate political and economic power that comes with extreme wealth. From 1945 to 1975 that countervailing force was high marginal tax rates and strong labor unions (and Glass-Steagal, but that is yet another story). Today we have... Barack Obama.